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Pension Reform In South Africa
by Ingrid Goodspeed,
Governor SAIFM

ocial protection is generally considered to be public measures to provide income security to the population of a country. It is increasingly held that assisting individuals, households and communities to deal with the various risks they face will accelerate poverty reduction and sustained economic and human development.

The elderly, specifically the elderly poor, is one of South Africa’s most vulnerable groups. Consequently pension systems are one of the most important institutions in South African society because they determine the living standards of millions of citizens of South Africa and play a decisive role in the South African economy. This article outlines recent developments in the application of social protection in the form of pensions – specifically the proposed pension reform referred to in Mr Mbeki’s state of the nation address on 7 February 2007 and Mr Manuel’s budget speech two weeks later. The first four sections of the article are definitional and address the definition of pension systems, the role of government in pension systems, the objectives of pension systems and the key dimensions of pension system design. Thereafter the pension reforms proposed for South Africa will be analysed in terms of the key design dimensions. Finally concerns around the proposed reforms will be discussed. A glossary of terms is provided.

Introduction
In the State of the Nation address on 9 February 2007 Mr Mbeki stated that the government was exploring the introduction of “an earnings-related contributory social security system that is informed by the principle of social solidarity. This will mean that all South Africans will enjoy membership of a common, administratively efficient social insurance system, while those earning higher incomes will be able to continue contributing to private retirement and insurance schemes”. Two weeks later (21 February 2007), the Minister of Finance in his 2007 Budget Speech confirmed that “the time has come to put in place a new arrangement in which all South Africans will share, and that provides a basic and social protection system that meets the needs of low-income employees. We are therefore proposing a mandatory, earnings-related social security scheme to provide improved unemployment insurance, disability and death benefits targeted at the income needs of dependants and a standard retirement savings arrangement.”

At the end of 2004 / beginning of 2005 the total value of South Africa pension assets is estimated at R1.5 trillion (see table 1). There were 13 609 funds with 11.4 million members.

Pension systems defined
Pension systems are designed to provide an income to those individuals who experience a loss in earnings capacity through advanced age, a disability, or the death of the wage earner in the family. Pension systems can facilitate direct transfers from the government to these particular target groups. In addition, pension systems can provide a mechanism whereby individuals insure themselves against the loss of future earnings.

Role of government in pension systems
Governments generally have a two-fold role in pension systems. Firstly they are direct providers by directly paying pension benefits. Secondly as regulators, governments mandate participation in pension plans of employers or private pension providers.

The reasons generally cited for government involvement in pension systems are:

  • Short-sightedness: Young, healthy workers may suffer from short-sightedness and not think about old age until it is too late for them to take adequate steps to provide for themselves.
  • Moral hazard: workers may consume as much as possible when young, with the expectation that society will care for them when they are old.
  • Long-term poverty: people are too poor to save during their working years.

Objectives of a pension system
The objectives of a pension system are poverty reduction and consumption smoothing.
Pension systems reduce poverty by providing non-contributory pensions to the elderly or disabled poor. The pensions are financed directly through general tax revenues. In South Africa the current old-age grant significantly reduces poverty among the elderly poor and many of their dependents.

Pension systems should smooth consumption between working and retirement years, such that individuals do not experience a substantial drop in living standards when old age or disability reduces their earning ability. The International Labour Organization suggests a minimum standard of 40% of an individual’s wage for 30 years of work.

Dimensions in the design of national pension systems
The key dimensions in the design of national pension systems are:

  • Coverage: is coverage universal?
  • Participation: is participation mandatory or voluntary?
  • Contributions: is the pension system non-contributory i.e., pension are revenue-financed and means-tested or are contributions earnings-based?
  • Benefits: to what extent do benefits i.e., annuities reflect the life expectancy of a retiree at retirement? In this respect there are two schemes under consideration: defined benefit and defined contribution schemes;
  • Funding: to what extend do fund assets cover future fund liabilities? Financing mechanisms are generally of two types: pay-as-you-go or fully funded.
  • Management / ownership / governance: is the system public, private or a mix of the two?
    Analysis of the pension reforms proposed for South Africa

The World Bank’s benchmark for pension systems and reforms is detailed in its publication Old-age income support in the 21st century, which suggests a pension system should be composed of some combination of the following five pillars:

  • Pillar 0 consists of a basic or social pension that provides the minimal level of social protection. It is funded out of national budget or general reserves;
  • Pillar 1 is an earnings-linked contributory public pension plan that attempts to replace some portion of income upon retirement. It is funded out of contributions with some financial reserves.;
  • Pillar 2: is a mandatory fully-funded obligatory occupational or personal pension plan;
  • Pillar 3 is a voluntary fully- or partially-funded occupational or personal pension plan;
  • Pillar 4 comprises other sources of support to the elderly such as informal family support, formal social health-care and housing programs and access to individual assets such as home ownership.

South Africa’s current standpoint on pension fund reform is outlined in National Treasury’s discussion paper Social security and retirement reform published in February 2007. It proposes a multi-pillar system consisting of:

  • Pillar 0: social assistance grants
  • Pillar 1: mandatory national social security system;
  • Pillar 2: mandatory private occupational or individual retirement funds
  • Pillar 3: voluntary supplementary savings.

From information in the discussion paper, an attempt has been made to analyse these pillars against the key elements described in item 5 above. This is shown in table 2.

This proposed multi-pillar approach conforms to the World Bank’s benchmark. Therefore its implementation should provide a social safety net and be an instrument for growth. However as National Treasury admits: “there is a great deal of further work to do in developing the details of the proposed social security system and associated retirement industry reforms”.

Concerns around the proposed reforms

Informal sector
Ideally pension fund reform should specifically cater for the informal sector.

National Treasury does seek to encourage voluntary participation in Pillar 1: National social security system by those in the informal sector. However there is no indication as to how this will be done. This is not surprising as it is particularly difficult to collect contributions from workers who are not part of the formal sector. Even determining income for groups such as farmers and the self-employed is easier said than done.

As an alternative to voluntary participation in pillar 1, expanding social protection reform to the poor informal sector could be fostered by the private-sector development and launch of micro-savings and micro-insurance products that can effectively and efficiently assist in long-term asset building.

Decisions of the poor dominated by short-term risks
The poor and very poor are exposed to diverse risks during their lifetime and old-age income provision is generally not high on their agenda. Vulnerability due to insufficient resources in old-age is likely to be dominated by short-term risks such as sickness, drought, flooding, unemployment and disability. Thus mandating participation in a public, earnings-related pension scheme for the very poor may be welfare decreasing. In addition its success will be highly dependent on a strong immaculate administrative environment.

Public administration of national funds
There is political risk in the public administration of pension funds. The risk ranges from restricting investments and investment returns to fund confiscation to meet political ends. In addition, governments and public institutions have repeatedly made decisions on old-age programs based on short-term demands rather than long-term benefits.

Public administration of South African national funds has a poor track record. Recent events include:

  • In a briefing to Parliament’s transport portfolio committee in March 2007 on the Road Accident Fund’s three-year strategic plan, the CEO reported that while the RAF had attained some stability, it was still insolvent. The fund has been troubled by a backlog of claims, high administration costs and widespread fraud and corruption. Its outstanding claims amount to R24bn nominal (actuarial liability of R32bn).
  • The 2005/06 financial statements of the Compensation Fund were disqualified because the auditor-general was unable to determine accuracy and completeness of the revenue contributions for the year of R2.9bn.
  • In September 2006 Parliament’s standing committee on public accounts resolved to request the auditor general to conduct a special investigation into the Unemployment Insurance Fund (UIF) to ascertain the cause of the UIF’s continued non-compliance with laws and regulations including the Public Finance Management Act.

National Treasury has not ruled out private sector administration and fund management and has indicated that this will be the subject of research and consultation during 2007. Should the decision be that a government agency is to undertake the administration and fund management of the national social security fund, the agency should subject to the same governance, risk management, transparency and disclosure requirements applicable to the private sector.

Conclusion
“Income insecurity in old age, and the vulnerability of families to death or disability or unemployment of a breadwinner, are challenges faced by all, rich and poor. South Africa has a well-established occupational and individual retirement funding industry that provides protection to many, and a substantial social assistance grant programme that provides income support to the poor. But between the means-tested grant programmes and tax incentivised saving, there is effectively no fiscal support for saving and social insurance; the basic, contributory, earnings-related social protection system is incomplete and uncoordinated.” (National Treasury 2007 p 38). It is this disconnect that the proposed pension reforms attempt to address. As always, the most difficult part of planning and implementing something is the detailed design rather than the overall concept.

Glossary

Defined benefit

Under a defined-benefit scheme, the benefits are defined, thus the final pension a member can receive is pegged, usually as a function of income expressed as a percentage of income per year of contribution. Should financing fall short, either the government in a public plan or the employer in an employer-based plan, must provide the pension. Thus the government or employer bears the risk in defined-benefit schemes.

Defined-benefit systems can be pay-as-you-go or fully funded. If fully funded, financial assets are sufficient to cover the plan’s liabilities. However, should investment returns fall in any particular year, employers are obliged to offset the lower returns by increasing their contribution.

Defined contribution
Under a defined-contribution scheme the contributions are defined hence the final pension is a function of the level of an employee’s and employer’s contribution plus any returns on investment. The contribution is specified as a percentage of wages, and contribution rates are specified for employees, employers and potentially, the government. The final pension is determined by the amount in the retiree’s pension account at time of retirement. Members bear the risk in defined-contribution systems.
Pay as you go
Pay-as-you-go plans offer defined benefits that are not actuarially linked to contributions. In pay-as-you-go pension systems, current workers make contributions based on their current earnings. These contributions are immediately used to pay benefits for current retirees. The workers making the contributions receive a promise from the government that it will pay benefits related to these contributions when the workers become eligible for a pension
Fully-funded
In fully funded pension systems, the financial assets of the plan are sufficient to cover the plan’s liabilities. Worker contributions are invested and investment earnings form an integral part of the benefits eventually paid.
Fund sponsor / plan sponsor
Entity that sponsors a pension fund. This could be a company or the government.
Social protection
Public measures to provide income security to the population


References
  1. Fox, L and Palmer, E., 1999 (September), New Approaches to Multi-Pillar Pension Systems: What in the World Is Going on?, International Social Security Association.
  2. Holzmann, Robert and Hinz, Richard, 2005, Old-Age Income Support in the 21st Century, World Bank (www.worldbank.org).
  3. Minister of Finance, 2007, Budget Speech, www.treasury.gov.za.
  4. Myners, P., 2002, Institutional Investment in the UK, www.hm-treasury.gov.uk.
  5. National Treasury, 2004, Retirement Fund Reform, www.treasury.gov.za.
  6. National Treasury, 2007, Social Security and Retirement Reform, www.treasury.gov.za.
  7. President of South Africa, 2007, State of the Nation Address, www.gov.za.
  8. Schwarz, 2006, Pension System Reforms, World Bank (www.worldbank.org).
  9. World Bank, 1994, Averting the Old Age Crises, World Bank (www.worldbank.org).

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